by Scott Fearon
“We messed up,” she said flatly. “We made a terrible mistake and now we’re paying for it. But it’s not too late to turn things around. We’ve still got access to capital, and we’re in the process of returning to what made us successful in the first place—highly original products from around the world.”
“So the treasure hunt formula is coming back?” I asked.
“It’s already back,” she replied with a smile. “We’ve cut out high-end furniture altogether, and we’ve increased our emphasis on lower-priced gifts and consumables. Now we’re just hoping that our customers will continue to come back, too.”
“What about the recession?”
Jane laughed. “We’ve been in our own personal recession for years now, Scott. You’ve been coming here regularly for a long time. You know we’ve been struggling to keep our heads above water. So really, we’re in a better position than a lot of other retailers. We’ve already closed our worst-performing stores, and we’ve made the strategic changes to be competitive in this environment. Everyone else is just now starting that process and trying to catch up.”
She proceeded to list, from memory, the latest sales numbers to back up her assertions. I never saw her glance at her notes once. Cost Plus was already seeing an increase in the number of customers coming into its stores. Turns were going up, as well. To top it off, Jane showed me that, even after all its troubles, the company still had access to a large line of credit that it had arranged years earlier and had never come close to exhausting. That might have been the most impressive piece of data she shared. Probably more than any other industry, retailers desperately rely on lines of credit. Without them, they can’t stock their stores or pay their expenses. The fact that Jane and the rest of Cost Plus’s leadership had safeguarded its credit while so many others were being frozen out by the banks finally proved to me that the company had a decent shot at staying out of bankruptcy.
As I strolled out of Jane’s office, I began to worry that my Cost Plus investment was in trouble, and that I, too, had better start thinking about shifting strategy. I covered my positions in four different trades during the first half of 2010. CPWM was already up to $3.50 by the middle of that year, and it didn’t show any signs of stopping. At the same time, the number of Wall Street analysts who were covering the stock had dropped from well over a dozen just a few years earlier to exactly one—and he was still giving Cost Plus a negative rating. In other words, the company was in the opposite position it had been in when I first started visiting its headquarters in 1999. Back then, it was the darling of the retail sector, with a whole chorus of analysts singing its praises. As a result, its share price had been bloated beyond what its earnings merited. But now that it had been forgotten by Wall Street, Cost Plus’s stock was starting to look like the Chilean wines it was famous for first bringing into the country—a tasty and underrated bargain.
As is my habit, though, I didn’t rush to buy. I waited to see how the company fared during 2010’s holiday season. That hesitancy cost me a few dollars. The stock was near $8—almost exactly the amount at which I had shorted it four years earlier—when I finally started buying. Cost Plus had posted good holiday sales, and the rest of its numbers continued impress, too. In early 2012, it announced another strong Christmas season and the stock rose into the high teens. Then, in May, the company’s board accepted a buyout offer from Bed Bath & Beyond (stock symbol: BBBY) for $22 a share.
As I’ve said repeatedly, failure in business (and in investing) happens more frequently than success. Acknowledging that fact instead of pretending it isn’t true has helped me make a lot of money. But finding great companies to invest in over the long term is still my bread and butter—and for good reason. Going long on successful businesses will always be the best way to earn outsized returns.
My experience with Cost Plus bears this out. All told, after waiting three years for it to go to zero before I finally covered my position, I made about $1 million shorting its stock. That’s not a bad return. But when I bought the same amount of stock as I had shorted (225,000 shares), I netted more than $3 million in just over a year. That’s triple the money in a third of the time—and even that is a relatively modest profit when it comes to successful longs. Think about how much I would have earned on Costco and Starbucks if I had bought their stocks after my trip to Seattle in 1992. We’re talking about once-in-a-career-type investments that doubled and doubled and doubled again many times over. You just don’t make that kind of money on shorts. There’s a fixed number between a stock price and zero, and that’s as much as you’re going to get out of those positions. For long investments, however, there is no such limit.
The people who bought in early on one of the most stunning and successful corporate turnarounds in recent history, Apple, know how profitable long investments can be. Actually, Apple has come back from the dead several times in its history. But its most impressive revival came after Steve Jobs took the company away from what had been its core business for decades, the personal computer. First, he reinvented how consumers bought, listened to, and shared music with the iPod. Then, a few years later, he turned cellular phones into Star Trek–level computing devices with the iPhone. Of course, Jobs has already been praised to the moon for these ingenious inventions—as well as the iPad, the last of his revolutionary advances before his death—but it’s hard to overstate how bold he was in bringing these devices to market.
The vast majority of corporate leaders spend their energies inventing reasons not to change. Even when faced with clear—you could even say Blockbuster-sized—evidence that they have miscalculated or that the old ways aren’t going to work anymore, they willfully don blinders while the rest of their industry shifts around them. Apple could have continued to rely on PC sales, like its competitors Dell and Gateway did, and it probably would have muddled along in its niche. Instead, Jobs took the company into not one but two completely new sectors and transformed Apple into the largest tech company in the world.
Going Long
Since the financial crisis of 2008, I’ve had to adjust my investment approach toward more long investments. I still look for dead companies walking, but my fund is weighted far more on the long side now. Short selling just isn’t as profitable anymore, and there are four primary reasons why.
First, because of fewer IPOs and a continuing trend of public companies going private, the number of US stocks over $1 a share shrank from over seven thousand in the late 1990s to under five thousand by early 2014. Second, Sarbanes-Oxley and other new regulations have reduced the number of companies using aggressive accounting. That means there are not only fewer public companies in the market these days, there aren’t that many potential frauds to sell short, either. Third, with the Federal Reserve shrinking interest rates to goose the economy, prime brokerages began to charge short-sellers a daily “negative rebate fee” to make up for the interest the brokerages used to earn by reinvesting the proceeds of short sales. In 2013 alone, my fund paid more than $2 million in these fees. Short selling is already a very risky activity. Paying millions just for the right to potentially lose millions more makes it downright perilous.
Finally, people in my business have simply gotten better at their jobs. The number of hedge funds hunting for short ideas has exploded, as most managers justify their high performance fees on the basis they can add value (and protect capital) using both shorts and longs. Not only that, hedge fund managers are a lot smarter nowadays than they were when I started out. That means the competition for the handful of good shorts is intense.
I wasn’t smart enough to buy Apple before its stock took off in the mid-2000s and went from $50 to almost $800 a share a few years later, but I’ve had my share of wildly successful longs. Once in the bluest of blue moons, you climb into a stock, strap yourself in, and hold on for dear life as it rockets up into the stratosphere. I’m not like the newsletter writers or promoters on cable tel
evision who try to act like those kinds of winners are everywhere. They’re not. But if you do this long enough and you know what to look for, you can find them.
A Tarnished Gem
The reasons for Cost Plus’s decline should be familiar if you’ve read this far in the book. Its previous leadership committed a whopping four of the six business sins I look for in dead companies walking. First, they got caught up in the housing mania and abandoned the treasure hunt atmosphere that had defined the brand’s identity. Second, in a move that could be seen as a smaller prelude to JCPenney’s disastrous firing of its own customers in 2012, they alienated Cost Plus’s core customer base by killing off that eclectic atmosphere and stocking more expensive and slow-selling furniture. Third, they followed the flawed formula of hypergrowth, opening too many stores too quickly. And finally, when they were confronted with clear evidence of the negative consequences of these strategies, they cast around for external factors to blame instead of recognizing their own culpability.
Even one of these misguided decisions could have damaged the business enough to sink it, but all four together made bankruptcy seem inevitable. Throw in the fact that at the same time Jane and its other new managers were trying to repair the company, the wider economy was mired in the worst supercycle recession in almost a century, and Cost Plus’s recovery starts to look almost miraculous. But there was nothing supernatural about its return to success. It was just a matter of an executive team taking responsibility and making better choices. Sure, they did so at the last possible moment before the company went under. (We’re not just talking the eleventh hour. It was more like the eleventh hour and fifty-nine minutes. Remember, shares of Cost Plus were trading for pocket change at the stock’s low point.) But that just goes to show how effective smart, clear-eyed, and personally engaged leadership can be.
Another corporate Lazarus that I was lucky enough to discover made many of the same mistakes Cost Plus did and brought itself just as close to bankruptcy. For most of its long history, the jewelry retailer Zale Corporation (stock symbol: ZLC)—known as “America’s Diamond Store”—had earned the majority of its revenues on bridal jewelry like diamond engagement rings and other exclusive merchandise. The company didn’t target the same wealthy buyers as Tiffany. Most of its stores were, and still are, in shopping malls. They were places where predominantly middle-class consumers went to buy loved ones tokens of their devotion, often by using the company’s branded store credit card. But in the mid-2000s, right around the time Cost Plus’s management decided to turn its quirky bazaars into luxury furniture showrooms, the leaders of Zale inexplicably went the opposite direction—they shifted the company’s inventory to include a much broader assortment of inexpensive, kitschy items.
The industry term for these kinds of lower-end pieces is “fashion jewelry,” but it would have been a stretch to call most of what Zale was offering jewelry. Baubles was a more fitting word. (One of its lines was Hello Kitty–branded tchotchkes like bejeweled iPhone cases.) Compounding this already questionable business move, the company attempted to make up for the lower margins these kinds of items earned by following the dreaded hypergrowth formula. It expanded its number of locations aggressively, betting that higher sales volumes would bring higher profits, too.
Zale’s switch to cheaper trinkets worked about as well as Cost Plus’s attempt to go upscale—meaning, it didn’t work at all. The new merchandise put off the brand’s core, middle-class customers. Even before the economic meltdown of 2008, same-store comps were dropping and operating margins were following suit. Nonetheless, the company’s leaders forged ahead with their “value-oriented” strategy, and things went from bad to worse. After a disappointing holiday season in 2007, they tried to clear a massive backlog in unsold inventory by staging prolonged clearance sales, offering deep discounts on already discounted merchandise. These efforts only dragged profits lower, not to mention the company’s share price. ZLC declined by more than two-thirds in 2007, from the high twenties to the mid-teens. At the end of 2008, as the interminable Great Recession was only beginning to set in, ZLC was a $3 stock. The company lost almost $200 million in fiscal 2009, and its share price dipped below $1. Meanwhile, its debt swelled to almost $500 million. By the time the board of directors cleaned house and brought in a fresh management team in January 2010—after yet another rotten Christmas season—America’s Diamond Store was looking extremely rough.
New CEO Theo Killion made some immediate improvements. He began to close many of the company’s unprofitable locations. He also cleared as much low-priced fashion jewelry from the remaining stores as he could. Those moves, plus a critical cash infusion from a private equity firm, kept the company from going all the way under—in the short term, at least. When I first visited Zale headquarters in Irving, Texas, in November 2011, its stock had crawled back over $3. But it was still a long way from being anything close to a profitable concern. Its debt load was still enormous, it was still losing money, and the all-important Christmas season was looming. Without a good holiday quarter, ZLC could have very easily turned into a lump of coal after all. Nonetheless, I sensed an almost giddy energy in the two executives I interviewed, the newly hired CFO Tom and the head of investor relations, Roxane.
“We’ve closed more than forty of our worst-performing stores, and we’ve had four straight quarters of positive same-store comps,” they told me excitedly, almost talking over each other. “And we’ve just announced an exclusive agreement with Vera Wang to sell her designer bridal jewelry.”
Most of my meetings with corporate executives are pretty drab affairs. Chief financial officers aren’t generally known for their rah-rah enthusiasm, which is why that first visit with Roxane and Tom stands out in my mind. Sitting across from them as they ticked off one positive data point after another, I almost felt like I was attending a corporate pep rally. Don’t get me wrong; they were quite poised and professional, and nothing they claimed was inaccurate, but they were clearly happy to come to work every day. It took me a little while to realize what I was sensing in them: pride. It was obvious from their attitudes that they were extremely proud to be a part of the company’s turnaround, and who could blame them? They and their fellow executives were doing everything they could to save an iconic, even historic, American brand. Zale had been around for almost ninety years. It had survived the Great Depression, World War II, and countless other ups and downs. To hear them talk, it was going to make it through its latest and most severe crisis, too.
Nonetheless, there was no way I was going near the stock. Not yet. Despite Tom and Roxane’s infectious optimism, I’d heard too many executives at troubled companies cheerfully predict imminent recovery, only to see them file for bankruptcy a short while later. As I drove back from Zale’s offices back to downtown Dallas, I was hopeful the company would recover. But I was far from convinced that it would.
Fortunately, that skepticism didn’t cost me very much money.
I didn’t make it back to Irving, Texas, for almost a year and a half. ZLC was still below $5 at that point, but the company was obviously well on its way to something it hadn’t enjoyed for half a decade: profitability.
Roxane smiled as she led me into her office and happily rattled off another laundry list of positive developments. The company had now seen ten straight quarters of positive comps. It had closed another several dozen unprofitable stores and was actually starting to consider opening a few new ones. Best of all, the previous holiday season had gone even better than expected, and the company’s exclusive Vera Wang and Celebration diamond collections were now responsible for almost 15 percent of its revenues and counting. That last detail impressed me the most, because it demonstrated that Zale’s leadership was not just trying to reverse the bad decisions of the previous management team, they were also committed to something that even executives at thriving concerns usually have a hard time accomplishing—innovation.
In t
he midst of lean times, most businesses assume the corporate equivalent of the fetal position. This usually means draconian cutbacks, layoffs, and asset protection. Zale had definitely done its share of cost cutting by closing as many unprofitable stores as it had. A lot of analysts gloss over how difficult that process can be. It’s extremely arduous to shutter so many locations. But that wasn’t what convinced me to buy a big chunk of stock in the company after my second visit. Slashing expenses was necessary for Zale to recover. But what made me believe that its stock was undervalued was management’s determination to grow profits by investing in new products with better margins. Instead of sourcing cheap fashion jewelry from outside vendors, it was now actively creating and marketing high-quality, in-store collections. These not only earned Zale higher returns, they vastly strengthened the overall brand.
Consumers, even middle- and working-class consumers, do not want the jewelry store where they buy their wedding bands or other cherished items to seem like a glorified trinket shop. They want to feel like they are getting a good price, but they also want to believe that the products they are investing in are as special and lasting as the devotion they feel for their loved ones. Diamonds are supposed to be forever, and it’s hard to feel like you’re wearing something timeless when you picked it out of a clearance case next to a Hello Kitty keychain. Unlike the previous regime, Zale’s new management obviously understood that essential aspect of their business, and they were willing to invest in repairing the brand’s image by stocking quality new products.
I also appreciated that Zale had adopted what amounted to an anti-hypergrowth strategy for its recovery. The company was paying down debt, closing unprofitable stores, and doing everything it could to boost profit margins. It had even signed a new agreement for an in-house credit card, which would save it up to 2 percent on one-third of all transactions. (The previous management had inexplicably outsourced its credit card business to Citibank.) Thanks to these measures and its commitment to growing its own exclusive product lines, its gross margin had surpassed 50 percent for the first time in years by the time of my first visit. Five months later, when the company announced its full fiscal year results, those margins were at record levels. Combined with its debt repayment and other cost reductions, Zale showed positive earnings per share and operating margins of almost 2 percent for 2013—not great, but a hell of a lot better than the losses the company had been posting.
